International Markets Produce Mediocre Returns

Posted by Larry Brundage on July 20, 2011

For the second quarter of this year, mediocrity seems to be the name of the game for the international equity markets. The iShares ETF that tracks the developed markets equity index (MSCI EAFE) returned a scant 2.1%, while the ETF that tracks the MSCI emerging markets index lost 1.2%. These returns bracketed SPY (an ETF that tracks the S&P 500) whose total return was a flat 0.0%. The out performance of the S&P 500 in the first quarter leaves it ahead for the year with a 6.0% return versus 5.4% for the developed markets and 0.8% for the emerging markets.

In our list of single country ETFs there were eclectic groups at both the top and the bottom of the performance list for the quarter. The top performers included New Zealand 10.7%, Indonesia 7.8%, Switzerland 7.4%, Ireland 7.4% and Germany 6.3%, while the worst performers included Peru -16.3%, Israel -5.9%, Russia -5.9%, Canada -5.1% and Turkey -5.0%. As is often the case, currency can play a strong role in these performance numbers since they are presented in U.S. dollar terms. On the upside, that was particularly the case for New Zealand, whose currency was up 8.8% and Switzerland, which experienced an 8.6% increase relative to the dollar. Neither country seems to be working as hard as the United States or the European Union to debase their currencies.

While at times it appears that the countries that make it into the top or the bottom group are somewhat random, in fact there are often sound fundamental reasons for their performances. For example, New Zealand’s economy has been growing much better than was forecast by their central bank (up 0.8% in the first quarter versus a forecast of up 0.3%). This news came in the second quarter along with a rebound in earthquake- damaged consumer confidence and lower central bank interest rates.Other highlights from the top and bottom groups include:

Switzerland: A calm stable country in the midst of a European financial storm.

Ireland: Part of the high debt group of countries affectionately known as the PIIGS. Ireland appears to be the most serious of this group in attacking their problems, as well having the best historical track record in the group for sensible management of their economy.

Germany: With probably the best managed economy in the European Union, Germany is benefiting from its relative strength. Looking forward, we are more concerned that Germany may be dragged into the economic maelstrom as it is increasingly called on to support the weaker countries. Additionally, we worry that should the weaker countries default on their loans, German banks which hold many of those loans will not be able to provide the loan growth needed in an expanding economy.

Peru: An economic basket case in the 1980s, Peru has been a rising star among South American economies since the presidency of Alberto Fujimori began in 1990 (not that we are touting his presidency as a whole). But, as is often the case in South American politics, populist sentiment began to be driven by resentment over economic inequality and Ollanta Humala was elected. Humala is a strong proponent of nationalizing industries and a good friend of Venezuela’s Hugo Chavez. Naturally the stock market reacted very poorly to this election and we would expect that it will continue to do so.

Canada and Russia: The markets in both of these countries have a large exposure to the energy industry (Russia more so than Canada.) While it may feel like energy prices, and oil in particular, have done nothing but go up this year, in fact that is not the case. Oil started the year at $91.38/bbl, rose almost 17% to end the first quarter at $106.72/bbl and declined almost 11% to end the second quarter at $95.42/bbl. As a result energy stocks performed poorly during the second quarter. We don’t have a breakdown of the performance by sector for the Russian and Canadian markets, but in the S&P 500, the energy sector was down 4.6% for the quarter.

In the second half of 2011, we expect continued mediocrity. While the economic problems in Europe have receded from the headlines, they have not been solved and will likely cause further turmoil. For Greece in particular, debt is about 150% of GDP and likely to rise to 170% of GDP during the next 2 years. No economy can sustain that high of a debt load even with extensions of maturities and cuts in interest rates. Eventually there will be reductions in principal which will not only hurt banks in Germany, as we mentioned earlier, but also the banks in several other European countries.

Surprisingly, Japan may be a counterbalance to the European malaise in the second half of the year. After the devastating earthquake and tsunami in March, Japan’s stock market plunged and its economy slowed significantly. But economic activity appears to be rebounding much more quickly than had been expected and as a result there has been some strength in their equity markets. The iShares ETF that tracks the Japanese market, EWJ, increased 11.0% from the low on March 16th to the time of this writing, July 14th. The reason Japan did not make our top 5 list is that much of the rebound came in late March and it has only been in the last two weeks that it has started to strengthen again.

As we discussed in our January newsletter, an outlook like this might make one rethink one’s exposure to the international markets. Yet markets have a history of surprising investors and if you are sitting on the sidelines as a rally begins, you miss a sizable portion of your expected return. Additionally, the reinvestment of dividends, particularly in weak markets, can significantly enhance long term returns.

Being humble about one’s forecast of market performance is something that increases with experience for most investors. Thus it is with that thought in mind that we would maintain our exposure to the international markets. To close, here is an aside on humility from the speech Benjamin Franklin gave on the last day of the constitutional convention, September 17, 1787. Although Franklin wrote the speech, he was too frail, at 81 years old, to be able to deliver it himself. It is fairly short and in our humble opinion, well worth reading.

"The aim has always been for our work to be the bridge that connects clients from where they are today to where they want to be tomorrow."

R. Dario Quiros, President

About HFM Wealth Management

Hartford Financial Management, Inc. was founded in 1989 to offer a client-focused alternative to the common financial services model of investment management. Our firm has a duty to our clients to always place their interests ahead of our own.